Evergrande - China Faces a Potential Lehman Moment

The implosion of Lehman Brothers, 13 years ago this week, showed the world how the collapse of a single company can send shockwaves around the world.  Echoes from that event are resounding today as a massive Chinese property developer  teeters on the brink of default.

The collapse of Evergrande Real Estate Group - China's second-largest property developer with $310 billion of debt outstanding, could set off a chain reaction that spreads overseas.

Wall Street is keeping a close eye on the situation, which highlights the extraordinary amount of borrowing Chinese companies and families have taken on over the years.

For now, investors seem confident that authorities in Beijing would use their vast control over the Chinese economy to limit the damage. And there is no evidence, at least so far, of contagion in US markets.

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Transcript

Welcome back.  Just a quick video today on Evergrande, the struggling Chinese property developer.  There is a lot of news asking if the collapse of Evergrande will be Chinas Lehman Brothers moment.  Lets discuss.
So, Evergrande, is a huge company.  It is China's second-largest property company and the worlds most indebted property developer; they have liabilities of over $310 billion. So, it is a big deal.  In 2018 when Chinas central bank put together a list of companies that might pose systemic risks to the nation's financial system, Evergrande was near the top of that list.
The stock is down around 80% year to date, and the company appears to be insolvent.  Now, what might surprise you is that the company has never reported a loss and they have had current assets greater than current liabilities in every accounting period in the company’s history. So what is going on?
Well, Investors became worried about Evergrande around this time last year when a leaked letter from the company showed that they had begged the government for support to approve a now-dropped backdoor listing plan. The company claims that this letter was a forgery. The leaked letter said that the company’s liabilities involve more than 128 banks and over 121 non-banking institutions.
They admitted this Tuesday that they are under "tremendous pressure" and may not be able to meet their debt obligations. For a borrower of their size, late payments on these debts could trigger cross-defaults as many financial institutions have exposure to Evergrande via either direct loans or due to indirect holdings through different financial instruments. The idea is that a large financial institution could well be relying on receiving a payment from Evergrande to make a payment on its own debts.
It is not just the banks that might have problems. Evergrande relies heavily on customers paying for apartments before the projects are completed to finance construction. Hundreds of thousands of Chinese people have put down deposits on homes that might never be built.  Bloomberg reports that investors have made down payments on approximately 1.5 million properties.  They will owe a lot of money to suppliers too, who could go bankrupt iff they are not paid. Additionally, Evergrande has a wealth management affiliate that offers financial products to Chinese investors backed by the company’s credit.  They are renegotiating these loans right now.
Evergrande is also a major employer, it’s collapse would have a severe impact on the job market in China. The company has 200,000 employees and hires 3.8 million people every year for project developments. 
These problems obviously don’t come at a good time for China investors, coinciding with the Chinese government regulatory drive against big tech, the for-profit education industry, the real estate industry and other sectors.
Over the last few days, angry protesters have been gathering outside the company headquarters, demanding information. Investors are growing increasingly nervous that if Evergrande were to collapse, there could be a domino effect causing other property developers to fail, creating systemic risks for the banking system of the world's second-largest economy.
Real estate is one of the major engines of China's growth. It’s responsible for 29% of economic output, and a bankruptcy of this size would have major repercussions.
Many analysts are arguing that there is no way that Beijing would allow such an important company to go under as it would undermine the regime's stability.

So what went wrong?
Well the company burdened by a mountain of liabilities of more than $310 billion after years of borrowing to fund rapid growth. They stepped up acquisitions in recent years, taking advantage of a real estate frenzy. 

In August of last year, the Chinese Government introduced new measures to monitor and control the debt level of major property developers. This crackdown forced Evergrande to offload properties at increasingly steep discounts – reducing prices by up to 25% in order to deleverage.

One of the biggest problems for Evergrande, (which is a general problem in China) is that the reason the company is struggling having never reported a loss, is that bad investments in China are never written down.  If a company like Evergrande never acknowledges losses, they just show up on the balance sheet as inventory.  And Evergrande has a lot of inventory on its balance sheet.  Inventory that can’t be liquidated to pay off debts, because there is very little of value there to sell. At this point everything that can be sold has been sold or pledged against specific debts.

Early on when the company was growing a lot the shortfall could be filled with increased borrowing.  Their inventory includes undeveloped land, work in progress construction and completed inventory.  Analysts are claiming that the company may have capitalized $220 billion dollars of losses as current assets.  You have to wonder about the state of other property developers in China too.
  
Evergrande was downgraded by two credit rating agencies last week and its Hong Kong-listed shares have collapsed by more than 80% this year. On Monday, the Shanghai Stock Exchange paused trading in Evergrande's May 2023 bond after it fell more than 30%.

What is the company doing to save itself?
On Tuesday, Evergrande issued another statement to the Hong Kong Stock Exchange, saying it had hired financial advisers to explore "all feasible solutions" to ease its cash crunch.

The statement warned that there was no guarantee the property firm would meet its financial obligations.

The firm blamed "ongoing negative media reports"  for damaging sales in the crucial September period," – If you can’t blame short sellers, there is always the media…

Evergrande is trying to convince its wealth management customers to accept properties at steep discounts instead of cash repayments. Many have rejected this offer, which required them to buy in their home provinces and was subject to approval from local authorities.

The company’s founder has appeared in social media posts showing senior executives signing guarantees that they will complete ongoing projects. The company was working on 778 developments in more than 200 cities across China as of the end of June.

Should the company fail in a disorderly manner, there are severe risks of contagion.  Many are asking if the government will intervene, and how might they do that.  The Chinese government will not want to be seen to bail out the company but may wish to intervene to maintain stability.  There are many financial institutions involved, the majority of which are state owned, so the government could intervene through those channels without appearing to directly intervene.  You could see a big rescue program where the company debt gets exchanged for equity. The company’s founder was listed by Forbes as the third wealthiest man in China last year.  He may soon be due a place on my list of billionaires who lost everything.  If you haven’t yet seen that video, here is a link.

See you soon, bye.